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I came across this article in S & C Magazine regarding pairs trading,
which might be of use:
TRADING TECHNIQUES
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Exploiting Closely Related Stocks
Pairs Trading
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by Stéphane Reverre
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Some relationships in the stock market make for very profitable
trades.
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The arbitrage of Royal Dutch (RD) and Shell (SC) is a popular one on
Wall Street because it is a classic example of a pair-trading model,
a strategy that involves trading two stocks -- one long, the other
short-term based, on the assumption that their prices follow an
identifiable recurrent pattern -- backed by a strong relationship
between the companies. Essentially, RD and SC are opposite sides of
the same coin; they both derive their revenues from a fixed partition
of the income generated by the entire corporate group. Indeed, they
are linked by corporate charters stipulating that 60% of the income
received by the group will be allocated to RD, while the 40%
remaining will be allocated to SC. Therefore, it is possible to
extract an exact relationship between the two stocks' prices (see
sidebar "Pairs relationships").
The figure here showed Ratio SC/RD and MA(30) of SC/RD Ratio with
Ratio in y-axis and date on the x-axis.
FIGURE 1: PAIR RATIO. Though the mathematical relationship between
Royal Dutch and Shell is precise, actual market values vary.
For our purposes here, however, I want to imagine that I know nothing
of such a relationship. Why? In practice, discovering the potential
for pairs trading is usually the result of an automated correlation
calculation, rather than the fruit of time-consuming analysis of
corporate reports. By automated correlation calculation, I mean a
simple software program that computes correlation between stocks
regularly and automatically -- for example, every day after the
close. An automated correlation analysis would pick up a correlation
like RD/SC because the two naturally have a high correlation. The
approach is exactly like the process through which a trader would go
after having identified RD and SC as a promising pair-trading
candidate.
Figure 1 shows the ratio between the closing prices of SC and RD over
the two-year period from June 1998 to June 2000. The red line is a 30-
day moving average of the ratio and designed to capture the ratio's
stable value. In other words, the observed ratio has a base value
that can be approximated by the moving average, stripping out noise
due to day-to-day variations, and the moving average is my estimate
of this function. Thirty days is short enough for the moving average
to react to market conditions, but long enough to be reasonably
efficient in stripping out noise.
IDENTIFYING THE ARBITRAGE
Once I have an estimate of the ratio between RD and SC, I can compare
the market spread with what I think it should be. For example, on
July 8, 1998, SC closed at $41-1/4 and RD at $53-15/16. The 30-day
moving average of their ratio was 0.7725, which means that SC should
have been worth $41.67 ($53-15/16 * 0.7725). Because it closed at $41-
1/4, I believe it is undervalued by $0.42 ($41.25 - $41.67).
...Continued in the March 2001 issue of Technical Analysis of
STOCKS & COMMODITIES
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Stéphane Reverre received his MBAat Harvard Business School. He works
for Leading Market Technologies, a software company specializing in
analytical products targeted to institutional investors. Previously,
he worked at a French leading financial institution as an equity
derivatives trader in Tokyo and New York. He can be reached at
sreverre@xxxxxxxxxxxx
rgds, Pal
--- In amibroker@xxxxxxxxxxxxxxx, "Dave Merrill" <dmerrill@xxxx>
wrote:
> Has anyone developed tools in AB for market-neutral pairs trading?
>
> Specifically, I was wondering about...
>
> - An exploration to determine the degree to which market or sector
movement
> accounted for profit or loss of past trades.
>
> - A reasonable way of finding matching trade pairs, ie. trades
based on the
> same signal, but one long and one short, where the two stocks have
high
> correlation with each other.
>
> Thanks,
>
> Dave
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